28 February 2007

Keynesianism

Some updates and corrections have been made to this essay since posting (16 Aug 2013).

Keynesianism is the casual term used to refer to some economic theories and policy methods that were widely used between 1946 and 1980. These theories are named for John Maynard Keynes (1883-1946), although Keynes was actually the manager of the research group that developed Keynesianism.

Keynes had already won considerable fame for his work, A Treatise on Money, and had strong ties to intellectual luminaries of the day. Schumpeter's History of Economic Analysis (1954; p.1171) strongly implies that Keynes had already, in a sense, written the General Theory within the covers of the Treatise. I would argue that the General Theory was a milestone in the acceptance of market imperfections, such as sticky prices and corner solutions in factors markets, that had been growing for some time. The crucial departure of Keynesianism can be summarized as "imperfect markets," which meant,

prices may "never" adjust to reflect the intersection of supply & demand;

money is not neutral (i.e., disinflation or deflation has a serious impact on economic conditions; the available money supply, accompanied by a distinct market for cash balances, has an impact on real output);

factor markets, such as for labor, land, and capital, may sometimes not clear;

state intervention may sometimes cause more good than harm.

The last proposition is a bit difficult for some people to understand. Keynes had sought to establish a macroeconomic role for the state precisely so it could avoid a microeconomic (i.e., socialistic) one, and he attempted to establish clear, immutable boundaries for the state under conditions of economic emergency. These borders were not crossed by Keynes; for example, the Royal Commission on the Poor Laws (UK-1905-1909) examined mainly employers and economists, before setting up a system of compulsory unemployment insurance.1

However, there are essentially two key features of Keynesian economic policy that were widely adopted everywhere for many years: fiscal policy and monetary policy. Fiscal policy was based on a crucial term of art coined by Keynes, the "theory of effective demand," which acknowledged that supply did not create its own demand, and on occasion it was necessary for the national treasury to step into the breach with deficit spending. This could be achieved with public works spending of various kinds, or it could be accomplished by slashing taxes. Monetary policy consisted of influencing liquidity preferences, or the demand for cash, through shrewd manipulation of interest rates. In later years, it was understood that major national governments had significant, but limited, power to influence interest rates; and the tools for influencing them tended to be fairly blunt.

The other major introduction of Keynes, which was never really reversed, was the idea that the entire economy operated under peculiar rules. Keynes' core idea was that aggregate demand was a linear function of output, but contrary to Say's Law, this relationship is not 1:1. Rather, the marginal propensity to consume (out of production) is somewhat less than 1. Hence, as productive capacity rises, demand for output rises at a somewhat lower pace (Keynes, 1936).

This analysis supplies us with an explanation of the paradox of poverty in the midst of plenty. For the mere existence of an insufficiency of effective demand may, and often will, bring the increase of employment to a standstill before a level of full employ-[p.31]ment has been reached. The insufficiency of effective demand will inhibit the process of production in spite of the fact that the marginal product of labour still exceeds in value the marginal disutility of employment.

Moreover the richer the community, the wider will tend to be the gap between its actual and its potential production; and therefore the more obvious and outrageous the defects of the economic system. For a poor community will be prone to consume by far the greater part of its output, so that a very modest measure of investment will be sufficient to provide full employment; whereas a wealthy community will have to discover much ampler opportunities for investment if the saving propensities of its wealthier members are to be compatible with the employment of its poorer members. If in a potentially wealthy community the inducement to invest is weak, then, in spite of its potential wealth, the working of the principle of effective demand will compel it to reduce its actual output, until, in spite of its potential wealth, it has become so poor that its surplus over its consumption is sufficiently diminished to correspond to the weakness of the inducement to invest.

But worse still. Not only is the marginal propensity to consume [1] weaker in a wealthy community, but, owing to its accumulation of capital being already larger, the opportunities for further investment are less attractive unless the rate of interest falls at a sufficiently rapid rate; which 'brings us to the theory of the rate of interest and to the reasons why it does not automatically fall to the appropriate level, which will occupy Book IV.

Prior to Keynes, it was assumed that interest rates were the mechanism that brought saving, and hence, consumption, in line with production. Prior to Keynes, it was believed that, if consumption were to have risen more slowly than productive output, then interest rates would fall, reducing the propensity to save. That would, in turn, push consumption up to what it ought to be. In Chapter 15, Keynes explained that (a) interest rates play a fairly minor role in the decision to save, and in Chapter 17 (b) the connection between the rate of interest and the rate of saving is not real.

Keynes' contribution was therefore the aggregate supply-aggregate demand model of the economy. Almost immediately, his associates, Hicks and Hansen (see below) introduced the IS-LM model, which offered an elegant (if flawed) comprehensive model linking all all of the various states of the economy to interest rates and output.

One minor rebuke of the Keynesian system arises from its reliance on the IS-LM curve. This is more of a pedagogical criticism, since it is not really fundamental to the Keynesian analysis of the economy. The IS-LM has an unfortunate confusion over time; the derivation of the curves themselves don't specify a time horizon, but if the time horizon is long (say, a decade), then the implication is that markets OTHER THAN money and goods are totally passive; and if the time horizon is short (say, a quarter) then there's no role for inflation. On a personal note, I was advised to combine IS-LM and AS-AD, as I did in this 2002 class paper. This article does the same.

Vulgar Keynesianism
In retrospect, Usonian economists and writers on the same have tended to equate Keynesianism with socialism or even outright Communism (examples). It is fairly unusual to find this outside of the United States; for example, his [admiring] biographer, Baron Robert Skidelsky, is not only a Tory member of the House of Lords, he's also associated with many conservative thinktanks in the UK.

There's a long convoluted reason why this is so, which I cannot discuss here and now. But an obvious result has been casual abuse of both the term "Keynesian" and the concepts associated with it. Typically such abuse has been called "Vulgar Keynesianism." The most familiar example of this was the idea of using military spending as a form of economic stimulus. An extremely rare (almost unique, actually) example of a logically consistent anarcho-capitalist, David Stockman, bitterly objected to the idea of military spending to stimulate the economy; he referred to the (mostly military-oriented) space program as "orbiting socialism," and elsewhere in his book, The Triumph of Politics, castigated the Reagan Administration for its "socialistic" invoking of economic stimulus as justification for wasteful, overkill military spending. I will repeat that, with the exception of a tiny number of men, all in the political wilderness, the "free market" conservatives associated with the Reagan Administration were uniformly zealots in favor of military expansion, corporate giveaways, and deficit stimulus of the economy (to achieve irreversible political power).

This is not actually Keynesianism since (a) it loudly repudiated any connection with the intellectual underpinnings of Keynes' General Theory, and (b) consequently ignored the orderly system of analysis, such as the IS-LM curves or the Mundel-Fleming Model of international trade and capital flows, that allow such policies. Obviously, when a political leader runs a deficit while in office, and pleas for fiscal restraint when in opposition, he's just being a politician. "Military Keynesianism" is a defamation of Keynes since it equates utter lack of responsibility with a school of economic thought.

This pattern has continued long after Keynesianism itself was "discredited." Hence, in the 2004 presidential debates, the incumbent declared that he believed "if you raise taxes"—i.e., don't cut them—"in a recession, you'll get a depression." This is an example of a vulgar Keynesian position, since it focuses on the role of effective demand in the business cycle. Otherwise, the allegation that Keynesianism is "socialistic" because it acknowledged a role for the elected authorities in managing business cycles, is silly. Subsequent schools of economics have occasionally availed themselves of this rebuke for polemical reasons, but otherwise offer competing views for how the state ought to manage the economy.

Valid Criticisms of Keynesianism
While much criticism of Keynesianism was silly, some criticism was not. The Achilles Heel of the theory, so to speak, was the difficult transitional phase of the world financial system caused by the collapse of the Bretton Woods System. Some readers will object to this remark, on the grounds that it is excessively sympathetic to a school they consider well and truly "debunked." I advise them to read the essay by Robert E. Lucas & Thomas J. Sargent, "After Keynesian Macroeconomics" (PDF); Lucas & Sargent are, so to speak, the James & John of the Rational Expectations "Revolution."

Lucas & Sargent: There are, therefore, a number of theoretical reasons for believing that the parameters identified as structural by current [viz., "Keynesian"—JRM] macroeconomic methods are not in fact structural. That is, we see no reason to believe that these models have isolated structures which will remain invariant across the class of interventions that figure in contemporary discussions of public policy. Yet the question of whether a particular model is structural is an empirical, not a theoretical, one. If the macroeconomic models had compiled a record of parameter stability, particularly in the face of breaks in the stochastic behavior of the exogenous variables and disturbances, one would be skeptical as to the importance of the prior theoretical objection of the sort we have raised.

[...]

Macroeconomic models were subjected to a decisive test in the 1970's. A key element in all Keynesian models is a trade-off between inflation and real output: the higher the inflation rate, the higher is output (or, equivalently, the lower is the rate of unemployment).

In other words, Keynesianism was reasonable enough until a massive change in the international monetary system occurred, and an historically unprecedented negative technology shock arrived hard on its heels. Even then, it bears noting, the courtly Lucas and Sargent employ weasel words to jab Keynes: A key element in all Keynesian models, not Keynesian theory. In other words, the Phillips Curve trade-off between unemployment and inflation was a theoretical cul-de-sac stimulated by the times, not Keynes. Heavily modified, as all economic theories are in praxis, Keynesian theory itself could easily have incorporated some form of inflationary expectations.

Certainly the erratic "fits and starts" character of actual U.S. policy in the 1970's cannot be attributed to recommendations based on Keynesian models, but the inflationary bias on average should, according to these models, have produced the lowest average unemployment for any decade since the 1940's.

Again, this is accusing the implementation rather than the actual theory. The "models" to which Lucas refers were developed under conditions prevailing in the 1950's and 1960's, not the peculiar influence of Keynes. They reflected the tendency of professional planners and managers in all circumstances to assume conditions would persist as they had in the past.

A more apt criticism of Keynes lies not in his failure to carry the Neoclassicals' water for them, or to predict the sort of economic Hiroshima caused by the events of 1971-1979. No, the real problem was that Keynes relied too heavily on approximation by rules of thumb. Another problem was that the General Theory offered policy prescriptions that were valid only in conditions where economies were too large and isolated to be affected by international conditions. The Mundell-Fleming Model, mentioned above, resolved this shortcoming, but relied on highly stylized treatment of capital flows.

A final remark to be made is that there is a grievous pitfall in trying to treat the economy as if it were a natural science, like thermodynamics or mechanics. Subsequent theorists have actually attempted to re-direct the field of economics away from its use of equations simulating elastic collisions and other mechanical analogies, to equations that mimic irreversible events in nature, like heat transfer. This idea is just as doomed; as economic activities have their corresponding physical reality (I physically walk to the corner store and physically hand the clerk my money for her carton of milk), there will always be some truth to a physics analogy, but the truth will tend to be trivial.

1: Timothy T. Hellwig, "," Social Science History Spring 2005 29(1): 107-136. This footnote updated 19 July 2012; the article requires access to Project MUSE, but did not when I wrote this post in early 2007.

27 February 2007

The Rational Expectations Hypothesis (REH)

The Rational Expectations Hypothesis (REH) emerged in the early 1960's as a set of theories about the financial markets. At that time, the prevailing economic theory was Keynesianism, which had evolved massively since 1936 without much supervision from its namesake. The crucial departure of Keynesianism can be summarized as "imperfect markets," which meant,

prices may "never" adjust to reflect the intersection of supply & demand;

money is not neutral (i.e., disinflation or deflation has a serious impact on economic conditions; the available money supply, accompanied by a distinct market for cash balances, has an impact on real output);

factor markets, such as for labor, land, and capital, may sometimes not clear;

state intervention may sometimes cause more good than harm.

The last proposition is a bit difficult for some people to understand. Keynes had sought to establish a macroeconomic role for the state precisely so it could avoid a microeconomic (i.e., socialistic) one, and he attempted to establish clear, immutable boundaries for the state under conditions of economic emergency.

In the period 1946-1980, economists influenced by Keynes' system (and more decisively, by his apostles) devised a framework of economic research and policy methods that bypassed any assumption of an equilibrium. There was understood to exist a microeconomic realm, which included transactions among many buyers and sellers—and which was subject to familiar Neoclassical laws of economics—and there was the macroeconomic realm of inflation, interest rates, and factor employment, where a different set of laws applied. The chief divergence in this realm was that the market never completed its process of adjustment; it could easily stop "adjusting" to full-employment equilibrium without ever getting close.

The key objection to this was always in the financial markets, i.e., the markets for bonds, commercial paper, foreign exchange, or money equivalents. Specifically, Keynesianism models developed for government agencies tended to rely on assumptions of how the money markets would respond to government actions. Everyone reading this is no doubt accustomed to news reports of the Fed changing interest rates; but it's long been noted that the Fed has limited effect in that regard. Basically, if the administration is running a "structural deficit" and the national debt is expected to remain on a permanent upward trajectory, then a reduction in the federal funds rate (the shortest-term and lowest interest rate of all) will very likely lead to an increase in longer-term rates. This was interpreted as evidence that investors make purposeful, and therefore, rational, decisions.

From there, the REH evolved to encompass a greater scope of economic behavior. After all, money markets merely respond to professionally anticipated demand for money or credit. The real sector of the economy, the part that actually does stuff, also makes plans based on inflationary expectations. At this point, the departure from pre-1979 macroeconomics becomes a little more vivid. Whereas, Keynesian economics uses simple charts to map the entire economy (IS-LM; AS-AD), REH models abandoned such visually appealing charts. Instead of graphs linking liquidity preference to interest rates and real output (the LM curve), post-Keynesian analysis relies on modeling the utility-maximizing behavior of a representative individual through time, given certain limiting assumptions: savings occurs at the expense of consumption; labor occurs at the expense of leisure; taxation influences economic activity, and most importantly, strategies to save and work are guided by expectations of the future.

The behavior of an agent in response to economic conditions is represented as a mathematical equation, nearly always the Ramsey-Cass-Koopmans Model. The RCK model is pretty flexible, and any student can edit its objective or constraint functions to reflect new hypotheses. The purpose of doing so is to create a precise map of what happens when something happens to the prevailing conditions: a change in interest rates, a scheme of fiscal stimulus (deficit spending), or central bank interventions. The RCK model is the backbone of dynamic general equilibrium (DGE) schools of economic thought, which incorporate varying degrees of REH.

However, it is not correct to claim that all this was alien to Keynesian economics. The RCK model clearly evolved in the employ of David Cass (1965) and Tjalling Koopmans (1965), both of whom were addressing questions of long-term economic growth. Neither were concerned with fiscal or monetary policy; however, it is true that by assuming economic growth was, in effect, a function of capital accumulation, both were certainly reverting to a world in which aggregate demand was not an issue. Keynes himself devoted a chapter of the General Theory to the role of expectation in business cycles. But he did not consider expectations to be so sensitive as to respond reliably to plausible state policies, and so his exposition deals exclusively with the role of the business cycle. Not surprisingly, whereas REH tended to think expectations were something business planners used to combat the state (the "policy ineffectiveness propositions"), Keynes saw expectations as undermining the neoclassical assumptions of a self-correcting economy. Hence, Keynes' use of [adaptive] expectations tended to support the idea of fiscal and monetary policy, in contrast to the REH's school's position that [rational] expectations make both pointless.

Because REH assumptions could be adjusted within the DGE schema, economists have been free to tweak them to fit the available data. However, there have been grave shortcomings in the REH results. First, the REH predictions are especially resistant to falsification. The problem is that the algorithm for selecting coefficients on any RCK equation are determined from the historical data one is trying to fit. In my opinion, this is mere data mining. It's an adaptation of the statistical procedure called regression analysis, except that the procedure is also supposed to identify "technology shocks," or disruptive events that cause spikes in the steady growth of the economy.

Let's consider these technology shocks: a contentious matter in the early days of REH, skeptics asked for examples of them. REH proponents appealed to the principle of positive economics, arguing that the point was that their model explained what actually occurred, so technology shocks were merely stylized facts. But surely there would have been a body of literature on these all-important nodes in history, particularly as REH models tended toward a standard set of assumptions. Since no such equilibrium has occurred, each version of REH produces a different set of technology shocks. One could reasonably have expected the luminaries of the field to furnish a list of the greatest shocks, and some discussion of how they affected existing technology. Instead, the official story remains the same: it's a stylized fact, don't look at it.

Stylized facts are an understandable shorthand, but when they are constantly edited so the theory fits the observations, they don't converge to a stable version of reality. Instead, they lurch about every time the data set is increased, as with the passage of time. For this reason, I would have to say that I don't expect REH to perform better in a Bretton Woods-style crisis than Keynesianism did.

Structural Deficit: given a fixed tax code, fixed entitlement policies, and a roughly stable rate of direct government purchases of goods & services (G), a recession will cause tax revenues to fall and government expenditures to rise. This creates a deficit (or reduces the surplus, if there was one). Conversely, if the economy is in recovery, tax revenues rise and expenditures fall, causing the budget deficit to shrink or even move to a surplus.

An incoming administration has no control over the business cycle, and has little (if any) control over the duration of its tenure. Rhetoric aside, changes to the tax code or favorable trade agreements have effects over only long periods of time. So an administration that comes to office at the beginning of a recession may defend its deficit spending by pointing out that the state is structurally in balance; i.e., the inevitable recovery will bring with it a return to fiscal balance. The point is not trivial; if the deficit is structural, then money markets will have to assume that the state's growing debts will lead both to a higher demand for credit, and higher tax rates further off in the future.

Those interested in the so-called "Ricardian Equivalence Hypothesis" of Robert Barro, please note that one study of the historical evidence established a split between the structural and non-structural elements of deficits: non-structural deficits don't stimulate increased saving.

Stylized facts: a presentation of an empirical finding, usually in statistical format. An example is the result of a regression analysis, which might correlate many variables with GDP growth. One of the variables could be a dummy variable for "Protestant majority," which might have a positive coefficient; the stylized fact here is, "there's some favorable impact on economic growth from having a Protestant majority." But it's not a universally valid generalization; it depends on what explanatory variables one used, and what the data set was. Unless the data set is relevant to the conclusions one hopes to draw, it's not useful information.

When a regression analysis is done well, it will produce a set of stylized facts that, while individually inconsequential, can be used as a group to produce valid inferences. One of the arguments used by REH theorists is that, sure, their assumptions may be individually absurd, but as a rich system of equations, they are powerful analytical tools that produce useful results. Hence, a point-by-point rebuttal of REH assumptions is an exercise in futility.

25 February 2007

A Poem by Richard Wilbur

Rabbi, we GadarenesAre not ascetics; we are fond of wealth and possessions.Love, as You call it, we obviate by meansOf the planned release of aggressions.

We have deep faith in property.Soon, it is hoped, we will reach our full potential.In the light of our gross product, the practice of charityIs palpably non-essential.

It is true that we go insane;That for no good reason we are possessed by devils;That we suffer, despite the amenities which obtainAt all but the lowest levels.

We shall not, however, resignOur trust in the high-heaped table and the full trough.If You cannot cure us without destroying our swine,We had rather You shoved off.

I was looking for another poem when I stumbled across this one. Since I've been posting a bit about economics, it seemed fitting to discuss this poem. As we can see, Wilbur is talking through the voice of the owners of the swine, who have just lost them as a result of Jesus sending the evil spirits into their bodies. Typically, in New Testament stories there is a touch of the elaborate literary metaphor, like a joke: "The spirits are cast out, and because they are many, they possess an herd of swine."

Many readers complain that it was awfully mean of Jesus to send the demons into the swine, since the Gadarene swineherds depended upon them for their livelihood. I would tend to agree, especially since the region where Jesus lived was about as cosmopolitan as, say, the New York City of Taxi Driver. With so many different peoples in the region, it would have been reasonable to expect Jesus to be considerate of them all.

Except, it's interesting that there are three different Gospel accounts of the encounter: the above-linked Matthew 8, Mark 5, and Luke 8:26ff. In each place, the location is different, but the names are similar: Gadara, Gergasa, and Gerasa. One scholar, John Dominic Crossan, proposes that they stand for Caesarea (i.e., the place belonging to Caesar); the name of the demon, Legion ("because they were many") alludes to the military occupation of the region, and their request to be cast into swine seems be part of an age-old trope in martial taunts, that the enemy will revert to his "true" nature when defeated, and yearn to be degraded.

In Matthew there are two men, who are are "so savage that none could travel along that road." In Mark, there is one man, who lives in the tombs on the shore of the Lake (not on a road). But in Mark, much is made of the fact that efforts had been made "to secure him with fetters," and he is naked, and gashes himself with stones. Also, in Mark we are advised that there were two thousand pigs in the drowned herd. In Luke, nearly all of the details are the same, except no mention is made of the number of pigs; and the fate of the unfortunate demoniac is mentioned briefly: "The man from the devils had gone out asked to be allowed to stay with [Jesus], but he sent him away saying, 'Go back home and report all that God has done for you.' So the man went off and proclaimed throughout the city all that Jesus had done for him."

Luke's version is puzzling because the man wants to "stay with," or rather, leave with, Jesus. Jesus "sends him away," or rather, advises him to remain at home. The man then proclaims something that, according to Luke, is already well known: that Jesus restored a man to sanity, at the cost of some swine. Logically, this implies that the people in the city will forever be reminded of why it was they asked Jesus to leave the region for good. Finally: Jesus tells the man to report "all that God has done for you." But the man proclaims all that Jesus had done for him, which a Christian might find unremarkable, except that Jesus is elsewhere anxious to have his identity kept secret (e.g., Mark 8:27-30). The point of these variations, in my opinion, is that the story is not really expected to be believed literally, not by the authors. And it is to show that the details are used to emphasize the significance of the story: men possessed by demons are a menace to their neighbors and to themselves, demons are repulsive and prefer foul states to good ones, ordinarily people prefer to be secure in their possessions than to be free of demons.

In other words, it seems unlikely that the story is about Jesus actually driving a herd of swine into the Lake.

Jesus could not have been claiming to describe an actual encounter with legionnaires, though; had the Gospels been written after the Romans evacuated the region, it's possible it was inserted to make Jesus seem like a divine liberator—rather like a contemporary movie set in Occupied France, in which some terrible fate befalls German soldiers long before July 1944. It would then be a case of infantile wish fulfillment. Yet, Jesus' speeches tend to undermine the short-term resistance; he constantly excoriates the Israelites (Luke 11:29ff), and implies that the time for anti-Roman militancy is past. Perhaps Jesus is making a sardonic joke, that he tried to liberate the people from their Roman oppressors (Legion), but offended them by destroying their swine. Needless to say, Jews are prohibited from eating pork. Seen from this angle, it actually is a funny story.

So the question arises, what exactly is the story supposed to tell us? Following Crossan (see above), the historical Jesus might have been paradoxically notorious as a magician, and accompanied by legends of his powerful miracles; then, as he was absorbed into the organized belief system of the Hellenized world, the Gospels were scrubbed of disturbing miracles (a laal-Khidr), but not completely. (Now departing from Crossan,) one of these "miracles" was the heavily coded story involving some element of Roman power, such as a garrison of legionnaires. The demoniacs were two men, who were naked and unrestrained. Somehow, the men are made whole, while the demons who possessed them (again, Roman military personnel) are made to revert to their swinish nature, by doing something unmentionable. Roman military discipline is undermined, but the character of the imperial power's true nature is revealed: the conqueror is a pervert.

I am not insisting that this is the case, but it must be noted that there is a long, pre-19th century tradition of interpreting these miraculous events as parables in and of themselves. For example, the traditional orthodox interpretation of the Song of Solomon is a hymn of love between Christ and His Church—something that, at the very least, violates the literalist spirit of late 19th century biblical literalism. The casting out of Legion was taken to mean a universal spiritual cleansing, according to pre-fundamentalist commentators (e.g., see John Darby or Matthew Henry). The problem with those readings is that (a) they're really tiresome to read, and (b) they're arbitrary. In contrast, the urgent reality of the Levant in the 30's was that of occupation and sectional division. There was a phase of slavish devotion to the regime in Rome (e.g., naming Lake Kinnereth after the Emperor; numerous shrines to the Roman gods in Jerusalem), in contrast to other periods in which more professional administrators had sought to accommodate local sensibilities. The political has given way to the sectional and the ethnic: the Romans are now just a residual aggravation.

23 February 2007

Dynamic General Equilibrium

The dynamic general equilibrium (DGE) model of economic behavior is the one that has prevailed in public policy analysis for about 30 years now. In its early form, it tended to use, and was known as, the "rational expectations hypothesis" (REH) ; and a money-neutral version of the business cycle, or "real business cycle" (RBC) theory. In the years since, there has been a shift of emphasis away from REH and RBC, towards the design of the model itself (DGE). Hence, DGE methodology can specifically exclude some of the early assumptions, and incorporate their converse.

When students are introduced to the concept of equilibrium, what they are are shown is the intersecting schedules of supply and demand. A leftward shift in the supply curve—perhaps due to the depletion of a particular input—causes the price to rise and the quantity demanded to decrease. A rightward shift in the demand curve—perhaps due to a change in fashion—also causes prices to increase, but also causes the quantity demanded to increase too.

This is known as a partial equilibrium, since only a part of the determinants of the equilibrium are being looked at. In fact, professors are obligated to remind students that these conditions hold, "all other things being equal." If the supply curve moves to the right, we don't consider a sudden decrease in income, or a sudden shift rightward in the supply curves of other commodities.

Initially, the concept of general equilibrium appears to have been developed by Leon Walras (1870), and subsequently refined by Gustav Cassel (1918). Walras' original version did not fare well, but in the 1950's was revived by Kenneth Arrow and Gerard Debreu, and since then general equilibrium has evolved to become the essential governing idea of economic research.

In general equilibrium, all of the determinants of economic equilibrium are considered at once. This can be gone though a system of linear equations. The equations incorporate the utility functions of representative consumers, prior endowments of capital and labor, production functions (i.e., equations that provide the maximum output of commodities for an economy, given available labor and capital; see Egwald), and so on. The object is to create a mathematical representation of how an economy works.

Why?Part of the reason is to examine the more complicated results of external change. For example, in intermediate microeconomics, students are typically introduced to indifference curves and budget lines. This allows students to analyze the difference between the income effect and the substitution effect (both of which involve changes in demand caused by changes in price). But the curves in the textbooks are usually drawn arbitrarily, to make a particular point; Marshallian general equilibrium theory tended to resist integrating all of the elements of Neoclassical (Marginalist) theory into a formal, mathematical model.

Colander: Why did Marshall focus his analysis on partial equilibrium and not formally develop his conception of general equilibrium? [...] I think it is correct that he felt incapable of specifying a meaningful formal general equilibrium system, [...] because he demanded intuitive correspondence between math and his understanding of the economy. [...]

Marshall's recognition of the analytic intractability of the general equilibrium problem, given the math available to him, and his desire for concreteness in his economics, led him to shy away from abstract specifications of general equilibrium.

However, the work of Arrow and Debreu was to effectively synthesize the views of Marshall with Walras' (inter alia) notions of general equilibrium. In other words, Marshall's partial, "cross sections" of economic relations (like the indifference curve) are expanded into the additional dimensions required to allow for a formal, unique equilibrium for any given vector of determinant variables—capital and labor endowments, consumer preferences, technology (production functions) and so on.

A word on simplification: in order to represent something as complex as an entire economy with a series of linear equations, economists typically rely on a principle known as positive economics. Positive economics, in its most reduced form, merely asks that economic analysis be judged on the basis of its accuracy of predictions, rather than normative (value) judgments. An interesting corollary to this is that we are advised to consider an economic theory on the basis of its predictive performance, rather than the realism of its assumptions[*]. Hence, we might assume that the US economy consists of 300 million identical actors, rather than people varying widely in income, ability, or preferences. We might ignore the role of monopolies, or involuntary unemployment, or ignorance about the relevant policy preferences of monetary authorities, and that's all right, if the result provides a reasonably accurate or useful prediction of the future.

Variations on a ThemeAs mentioned above, DGE theory initially incorporated mathematical equations that "assumed" no liquidity constraints, rational expectations hypothesis (REH), and real business cycles (RBC). Initially, REH was considered to be identical to DGE, which is why you find all of the DGE ideas expressed in The Rational Expectations Revolution (cited below); Preston Miller's book wasn't entitled The Dynamic General Equilibrium Revolution, although six years later it might well have been: since 2001, usage of the term has sharply diminished.

Moreover, there are different systems of equations that may be used. The most common are those of the Ramsey-Cass-Koopmans model: the closed economy consists of a household with an exogenous labor supply over time. One good is produced in each period using inputs of labor and capital, and output in each period can be either consumed or invested. There is perfect competition in all markets and no taxes. Individuals are assumed to have an infinite horizon, and expectations by private agents are forward-looking and rational. Hence, all agents have perfect foresight because there is no uncertainty. These assumptions imply that the allocation of resources by a central planner who maximizes the utility of the representative agent is identical to the allocation of resources in an undistorted decentralized economy.

The dynamic component comes from the use of mathematical models to simulate the behavior of such an economy over time (an innovation of Edward C. Prescott's "Time to Build" paper, cited below). In such a model, the economy has predictable responses to various kinds of external shocks ("technology shocks"), each of which corroborate the others.

DGE models that incorporate assumptions of perfect market conditions and optimal agent responses tend to rely entirely on random ("stochastic") shocks to explain everything that actually happens. Some researchers, such as Edward C. Prescott, have sought to create simulations of an economy that replicate the behavior of the actual economy.

03 February 2007

The Auto Industry and its shortcomings

As you can see, I've been wandering about Youtube exploring videos. Normally I post about telecommunications/information technology (TCIT), but this is mainly because of my job. I'm obligated to be an expert in computer technology, but in a way, that's not the most interesting field of analysis. Computer technology is actually fairly boring because it advances through greater capacity; genuine innovation is rare.

The technology, or here, the failure to apply technology that exists, is the subject of this video. It's from 1991, another dire year for the US auto industry. Ten years later, Taken for a Ride (Jack Doyle) was published, outlining in lurid detail the numerous ways in which the gigantic US automakers battled tooth and nail against any accountability to the public. It's understandable that this industry, so large and multifarious it could be likened to a medium-sized nation, would resist outside compulsion, but it's more disappointing how it has resisted any other form of pressure to introduce technology long familiar to its overseas competitors.

In the 1980's, Japanese automakers responded to the pressures of the rising yen by transferring much of their production to the USA. The Japanese automakers might possibly have been responding to exaggerated fears of a backlash in the USA,* but the fact is that the Japanese economy faced a superabundance of investment capital, a trade surplus with the US, and massive net reserves of US dollars that had to be unloaded in a way that inflicted minimum damage to their portfolio; the Japanese population was getting older fast, which meant a dearth of industrial workers, and a steady deterioration in the relative value of the US dollar.

Japanese firms operating in the USA were to perform far better than their US counterparts, responding creatively to the peculiar challenges of the US industrial milieu. The video above does a surprisingly poor job of making its case; it compares American autos in production with a Japanese concept car, which never entered production. This might be called "comparison overreach"; Japanese firms are indeed vastly superior to their US rivals in implementing meaningful technology, and this superiority is depressingly consistent. But to compare the gas mileage of luxury cars to that of a never-built concept car is patently unfair. And why exactly do Japanese automakers excel in implementing technology of this kind?

My view is that Japanese manufacturers face a very different production-optimization function from that faced by American firms. The production-optimization function is roughly analogous to the "indifference curve" found in microeconomics, except that here, the tradeoff is between producing for different objectives: quality versus quantity.** In the case of the auto industry, quantity may take the form of features and styling changes, while quality takes the form of superior design, technology, and craftsmanship. American automakers essentially are internally optimized for making a lot of car, rather like a Soviet industrial combine, while Japanese firms traditionally have been focused on penetrating a market by achieving adequate levels of quality. Both nations' firms enjoyed lengthy periods of protected home markets from which they made forays abroad, but in the case of the US auto industry, the main objective was to promote auto use and acquistion by a public with no prior experience with cars. After the abrupt conquest of the market by Ford and GM, there was a need to differentiate products by price, while using essentially the same industrial methods for the entire lineup. Hence, instead of Cadillac offering better engineering and craftsmanship than Buick (since both were divisions of GMC), Cadillac simply heaped on features.

Here's another post on this concept._______________________________________________________* In early editions of Japan, Inc. (Shotaro Ishinomori, 1988), there is a conspiratorial theme in which American CEOs of tottering industrial giants gleefully exploit mobs of seething American autoworkers. In fact, there never was much of a backlash; Americans were largely exasperated at the management of major US firms, but had no widely-shared opinion as to how to fix this shortcoming. My basis for this contention is that 1988 and 1992 were both campaign seasons dominated by trade issues and unemployment concerns; in both, the candidates with strong anti-Japanese rhetoric (viz., Richard Gephardt—'88; Sen. Bob Kerrey & Sen. Tom Harkins—'92) were trounced early in the New Hampshire primaries.

A series of economists addressing the effects of personal choices (save versus consume) over an extended period of time developed something called the Ramsey-Cass-Koopmans model (PDF). This could likewise be applied to a firm making decisions over long periods of time. Even if the person making the choice is not especially far-sighted, the effects of the decision will lead to permanently changed long-term trends.

AFTERTHOUGHT: A ridiculous quibble, but not as trivial as it might seem: AT&T is repeatedly attacked in this video as the once and future monopolist. Technically, the firm once known as AT&T is no longer with us; the company now known as AT&T is the former Cingular Wireless. Cingular Wireless, in turn, is a product of some former Baby Bells which were broken off from AT&T in 1984. So we could argue that the new AT&T is essentially a Texas-based clone of the former NYC-based dinosaur. There's definitely merit to that argument, especially since the "new" AT&T has been named as the primary defendant in Heptings vs. AT&T, allegedly violating US law on behalf of the NSA. But is AT&T really the most plausible villain in the battle for control over the world wide web?

In one sense, absolutely. AT&T is now, not merely a despised monopoly in an insular American market for telephone services; it's a national champion in what could be described as the global cold war between Europe and US industry. American industrial giants have not been shy about appealing to national solidarity to the point of bathos. Surely, as the last employers in the nation lose ground to behemoths from the EU, our elected representatives will scurry to placate the survivors.

However, it seems more plausible that AT&T will be quietly integrated in a de facto cartel of European and Northeast Asian telecom operators, based on access to the UTMS telecom standard. AT&T would thus be just a North American office for a European telecom monopoly, and utterly irrelevant. The real focus will be on "content" vendors, like iTunes, Viacom, Disney, Time-Warner, or some future combination of these. The monopoly model involves a very thin layer of business integration, with ephemeral joint operations with other specialized monopolies. I could be wrong, though.